For instance, we confess to being somewhat flummoxed by the role “currency swaps” seemed to be playing in the ongoing saga of Greece’s wobbly financial condition. In today’s Heard on the Street, the Journal’s Richard Barley writes that Europe’s official numbers crunching body has decided “to ask Greece for more details on currency swaps it may have used to defer debt repayments,” a move Barley says “has reminded investors that all governments have huge long-term lurking liabilities not disclosed in their accounts.”

The closest the Financial Times came to an explainer was this passage on Greece and the arranger of some of these transactions, Goldman Sachs: “It is hard to deny that the Goldman deal did create an optical illusion. It involved some €5bn of currency swaps at off-market rates and its effect was to let Greece borrow money without recording it as part of its public liabilities.”

Luckily we were able to track down Darrell Duffie, a Stanford University finance professor, who was kind enough to explain some of the basics of currency swaps, how they can be used to help hide national debt and why he thinks there are a lot more swaps out there waiting to surface. Here’s a Q&A style, edited summary of our chat.

Q: First things first, what are currency swaps?

A: They’re long-maturity, over-the-counter derivatives. That is they’re bilateral contracts in which parties to agree to exchange long-term streams of interest payments in different currencies.

Q: So if I’m a country or a company, why would I want to enter into one of these agreements?

A: There are a lot of reasons. But one of the most common reasons is that you borrow money in another currency and you’re concerned about foreign exchange fluctuations. So for instance if I’m Greece, and I borrow dollars in the U.S., I have to pay that debt back in dollars. But say I’m worried that the U.S. dollar might strengthen against the euro. That could add a lot to my debt burden. So I might prefer to repay the debt in euros. Currency swaps are a common way of doing that.

Q: Alright, so why is the fact that Greece may have entered into these agreements thought to be a problem.

A: Well for the most part, plain vanilla swaps just represent an ongoing agreement to exchange interest payments in the future, with no exchange of cash up front. But in other instances, the two sides of the deal agree that there will be an exchange of money up front to one party, who will would then pay that back with higher payouts in the future.

Q: That essentially sounds like a loan.

A: You could make that argument. But the thing is, these currency swaps had not been accounted for as loans on the books of the national government. In terms of incentives, the main incentive is that it gets accounted for in a different way that allows you to report a lower amount of debt on the national level.

Q: So the fact that Greece apparently had these sort of off-balance sheet loans is this a big deal?

A: Essentially, it raises a lot of questions as to how many banks and how many countries entered into these sorts of agreements. The general speculation is that some other sovereigns did this with a number of banks over many years.

So, essentially, it seems that the whole currency swaps issue comes down to an accounting game for governments. As the EU Observer points out — (ht: ClusterStock) — that the eurozone is widening its inquiry into the use of currency swaps:

The Finnish politician said Eurostat had no evidence of other capitals using the swaps, but the statistics agency was also unaware of Athens’ activities until very recently.

Media reports over the weekend said Europe’s other chronic big spender, Italy, has also used the off-balance sheet items in the past to hide its debt pile.

Comments (5 of 5)

Mr. Swap - no, the stories have it described correctly and you have it wrong. Read my explanation below.

5:41 pm February 18, 2010

Mr. Swap wrote :

The currency swaps are nothing but a series of FX forward contracts that convert principal and interest of debt in one currency into that of another currency. These are simple and widely used. They are NOT complex or nefarious in any way. Companies and governments routinely borrow in different capital markets to diversify their sources of funding and then swap the FX debt back to their functional currency. The combination of the FX debt plus the swap will be economically equivalent to the borrowing in their functional currency. So USD debt + USD to EUR currency swap = synthetic EUR debt. The news stories on this seem to have it wrong. They report that Goldman paid Greece cash and entered into off market swaps so that the FX rate was not at current market and then Greece would report a smaller EUR liability. This is incorrect. If Goldman paid Greece money, then the equivalent EUR debt would actually be at a higher value, not lower. Strange how people are reporting on this story who seem to know what they are talking about but really have no clue. THis isn't fair to Goldman at all.

1:06 pm February 18, 2010

Dan Asta wrote :

US institutions are involved, but the real question is, who owns the contracts currently? Goldman Sachs, the company that did the deal with Greece, sold those to the National Bank of Greece. There are also other derivative plays on Greece with German and Swiss banks having landed with both feet into the chaos in Greece. Germany cannot afford to let Greece default, and kicking them out of the eurozone would push Greece to default. The IMF can't help either because the recession will not allow a Greek recovery in time even if it underwent IMF surgery. Greece is small and the IMF could keep feeding it, but ultimately there would be another Argentina scenario. The EU cannot afford to let that happen.

10:51 am February 18, 2010

stanley fatmax wrote :

This explanation isn't quite right either. Currency swaps usually involve an exchange of cash up front (currency A for currency B), it's just that it is generally at market rates that don't imply a loan. The idea is that the exchange rate is off market such that the country receives more of it's own currency up front than if it would have just exchanged the debt issuance proceeds in the spot market. Of course it has to pay back this excess via an off market exchange rate during the term and at maturity of the swap. And the other problem, in addition to that of disguised obligations as described in the Q&A, is that the sovereigns pay higher rates of interest for this financing than they would for issuing regular debt.

3:32 pm February 17, 2010

Michael Kingery wrote :

Looks to me like another keg of dynamite that we (Americans) may be sitting on. Is it unimaginable that US financial institutions are not in some way participating in this?

Thanks for reading MarketBeat. We would like to direct you to MoneyBeat, the Wall Street Journal’s brand new global blog. MoneyBeat unites MarketBeat, The Source, Overheard and all the Deal Journal blogs, bringing together all the market, M&A, IPO and hedge-fund news from those blogs into a 24-hour hub for finance news. Check it out and let us know what you think at moneyblog@wsj.com.

About MarketBeat

MarketBeat looks under the hood of Wall Street each day, finding market-moving news, analyzing trends and highlighting noteworthy commentary from the best blogs and research. MarketBeat is updated frequently throughout the day, helping investors stay on top of what’s happening in the markets. Lead writers Paul Vigna and Steven Russolillo spearhead the MarketBeat team, with contributions from other Journal reporters and editors. Have a comment? Write to paul.vigna@wsj.com or steven.russolillo@wsj.com.